What is Speculation in the Stock Market?

Instructor: Dr. Douglas Hawks

Douglas has two master's degrees (MPA & MBA) and is currently working on his PhD in Higher Education Administration.

In every financial market, speculation plays a key role. On some exchanges with cheap stocks, speculative trades are the primary trades happening. In this lesson, we'll discuss the role speculation plays in these financial markets.

Speculative Stock Transactions

Have you ever seen an advertisement for someone that claims to have turned $1,000 into millions of dollars? While the stock market makes that possible, it is extremely - extremely - unlikely. But, if someone picks the right trades and speculates accurately, there's no telling what might happen!

The stock market and all its fluctuations are entirely based on the millions of transactions that occur between buyers and sellers each day. Each of these buyers and sellers have different reasons for their activity, but all, at least a little bit, are based in speculation. As it relates to the stock market, speculation is the anticipation of future price movement based on a belief the market has inaccurately priced the stock.

While all stock trading has some degree of speculation, speculative trades have an especially high impact within financial markets. Speculative trades are trades that involve companies that, for some reason, have a high risk/high reward profile.

This means that there is a lot of risk in the investment, perhaps so much that one could lose a significant amount of money, but, if the trade goes well, it could appreciate rapidly and make someone a lot of money in a relatively short amount of time.

Speculative Trades

Most speculative trades involve new companies that may not have a history of profitability or positive cash flow, but that have a business plan or some other strategic advantage that entices market participants to buy shares of their stock.

For example, a newly established technology company may be seeking funding and turn to the equity financial markets. Because they aren't established, they wouldn't be listed on the New York Stock Exchange (NYSE) or NASDAQ. Instead, they would be published on what is referred to as 'pink slips'. The pink slips are an unregulated stock market, where many stocks trade for less than $1.

The pink slips, or 'penny stocks,' are very speculative. The high risk part of the speculative means that there is a very good chance that the investor may lose some, or all, of their money.

However, If you are able to buy a technology firm for $.10 per share, and the innovation they have hits marketing hard or they get by purchased by a larger firm, perhaps those shares move to $10 a share. That is a 100x return! If you originally spent $50 buying 500 shares, your $50 investment is now worth $5,000.

If you see or consider a trade opportunity like this and after your analysis it is clearly a 'lose it all or make a lot of money,' then you are likely looking at a speculative trade.

Risk and Return Opportunity

A stock price can fall all the way to zero, although you'll see many stocks on the pink slips that still trade at a fraction of a cent. These are the companies that are hanging on to their cash and liquid assets, or assets that can be easily converted to cash, for as long as they can, which is why they are listed so cheaply on the pink slips anyway.

Unlike companies listed on the New York Stock Exchange or other mainstream exchanges, these speculative companies are generally not making a profit and paying earnings back out to investors or reinvesting in their own growth.

Regardless of how much you invest in these stocks - if it's $10 or $1,000 - you have a higher than likely chance of losing all that money. But, the other side of that risk - albeit still very unlikely - you might have your money sitting on next year's Google and hit a homerun. Those trades, however, are very speculative. They are completely based on the slim chance that those trades might turn very profitable.

An Example

To summarize this lesson and bring it to life, let's make a friend. Jason just graduated college and his parents gave him $1,000 to use as he would like. He really has his eye on a new car, but that costs around $35,000 and he wants to pay cash.

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